Years ago, I found myself sitting in law school in Moot Court wearing an oversized itchy blue suit. It was a horrible experience. In a desperate attempt to avoid anything like that in the future I enrolled in a tax course. I loved it. I signed up for another. Before I knew it, in addition to my JD, I had a LL.M Taxation. I needed only to don my cape…. taxgirl® was born. Today, I live and work in Philadelphia, PA, one of the best cities in the world (I can't even complain about the sports teams these days). I landed in the City of Brotherly Love by way of Temple University School of Law. While at law school, I interned at the estates attorney division of the IRS. At IRS, I participated in the review and audit of federal estate tax returns. I even took the lead on a successful audit. At audit, opposing counsel read my report, looked at his file and said, “Gentlemen, she’s exactly right.” I nearly fainted. It was a short jump from there to practicing, teaching, writing and breathing tax.

Taxes From A To Z (2013): B Is For Bad Debt Expense

Most tax discussions about debt focus on debts that you owe. But what happens when the debt is owed to you? And worse, what if it’s pretty obvious that the debt isn’t going to be paid back? When that happens, you have a bad debt.

For tax purposes, you have to distinguish between business bad debts and nonbusiness bad debts. And yes, they are exactly what they sound like:

A business bad debt is generally one that comes from operating your trade or business.

A nonbusiness bad debt is, well, everything else.

You may be able to deduct business bad debts as an expense on your business tax return. The debt must have been created or acquired in your business or closely related to your business when it became partly or totally worthless. That usually includes goods and services which haven’t been paid for by customers. In other words, your basic accounts receivable or notes receivable. If you are unable to collect any part those receivables, the bit that remains outstanding is a business bad debt.

That’s the easy part, right?

Just because it’s a business bad debt doesn’t necessarily make it deductible. You can only take a bad debt deduction if the amount you were owed was included in your gross income for the year the deduction is claimed or for a prior year. This is almost never the case for cash method taxpayers (most of us tend to be cash method which means we report income when we receive it). Accrual taxpayers, however, report income as it’s earned; if receivables have already been claimed as income, a bad debt deduction for uncollectible receivables is appropriate. If you haven’t claimed the receivable as income, you may not take the deduction for the bad debt. In that case, it’s just bad luck.

All other bad debts are nonbusiness bad debts. Again, to deduct a bad debt, you must have previously included the amount in your income (for accrual basis taxpayers) or actually loaned cash to a third party. It must have been a bona fide loan: you can’t claim a bad debt deduction for money that you expected to receive but didn’t, such as payment for services or a promise to pay. You also can’t claim a bad debt deduction for a gift, so you have to prove that you expected to be paid back: if you lend money to a relative or friend with the understanding that it may not be repaid, it is considered a gift and not a loan. As a caution, the IRS will almost always consider loans to relatives and friends to be gifts unless you have documentation that proves otherwise.

Nonbusiness bad debts must be totally worthless to be deductible; it’s an all or nothing proposition since you cannot deduct a partially worthless nonbusiness bad debt. So that $1,000 loan to your former best friend? The one where she paid you back $100? It doesn’t qualify.

To prove that the debt is worthless, you have to prove that you have taken reasonable steps to collect the debt. A court judgment is great evidence but isn’t required. The more you have in writing, the better.

To claim a nonbusiness bad debt, you report it as a short-term capital loss subject to the capital loss limitations on a federal form 8949 (downloads as a pdf) in the year the debt becomes worthless. You will have to include a bad debt statement which includes a description of the debt, including the amount, and the date it became due; the name of the debtor, and any business or family relationship between you and the debtor; the efforts you made to collect the debt; and why you decided the debt was worthless. Tread carefully here; remember that the statement is submitted with your tax return and signed under penalty of perjury.

This area of tax law requires substantiation and can be tricky. If you have questions, be sure and check with your tax professional.

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